New Rules, Industry Changes to Push Gas Prices Higher

Gasoline prices are at their highest levels in years and will probably go higher this summer as vacation driving builds up.

The price of self-serve regular gas is hitting $2 a gallon in many areas of California and in the Midwest too--about 12% above prices a year ago.

But vacation driving is only one element in gasoline prices and supplies. To know where prices are going longer term, one must factor in a lengthy menu of regulatory changes and market factors. And it’s wise to keep an eye on one U.S. oil company that is a reliable barometer of industry trends.

Projections are bleak. Energy economist Philip K. Verleger Jr. says gasoline in California could go to $2.50 a gallon this year and perhaps even to $3.50 a gallon.

The simplest reason is “supply and demand,” says Verleger of Brattle Group, who advises energy companies and government agencies from a base in Newport Beach. He cites motorists’ love of generally low-mileage sport-utility vehicles as one factor behind U.S. demand for gasoline, which has grown faster than had been anticipated by government and industry.

Meanwhile, fuel supplies are tight because there is almost no spare refining capacity. Years of poor returns on investment led companies to close refineries and depart the business. One result is that the U.S. imports 6% of its refined gasoline to relieve shortages.

But California can’t relieve its shortages so easily. The state has special clean-air requirements for gasoline. So supplemental gas for California can be imported only from Finland or from Corpus Christi, Texas. And shipments from either location are made only under near-crisis conditions.

Beyond that litany of gasoline troubles, new environmental regulations in the United States and Europe are going to force major changes in the refining business in the next four years, reports analyst Douglas Terreson of Morgan Stanley Dean Witter in Houston.

After lagging behind the United States in environmental concerns, Europe is mandating the use of unleaded gasoline and imposing stern restrictions on sulfur in gasoline and diesel fuel.

In the U.S., starting in California, the additive methyl tertiary butyl ether is going to be taken out of gasoline. The additive was put in to help clean the air but is being phased out by the end of 2002 because waste MTBE compounds pollute water supplies.

Removing MTBE will be neither simple nor cheap. Initially, refinery output will decline by 10%, estimates Leslie Watson of the Long Beach office of Purvin & Gertz, an energy consulting firm. Removing sulfur will be arduous and expensive as well.

And other additives will have to replace MTBE to give gasoline sufficient octane to power engines without knocking. The additive-replacement question is pitting the state against federal regulation that is pushing ethanol, a corn-derived compound favored by Midwestern agricultural states.

Whatever happens, “modification will be required by almost every refinery in North America and in Europe to meet the stringent new specifications,” Terreson says.

The cost of all the changes could be as much as $12 billion in the United States and $9 billion in Europe, he says--not to mention 8 cents to 11 cents a gallon added to the price of gas at the pump.

As a result, more companies are likely to drop refining rather than undertake such expenditures.

Yet just at this time, Phillips Petroleum Co. is wading deeper into the refining business by bidding to acquire Tosco Corp., owner of the 76 brand and refining complexes in Wilmington and Carson and six other refineries nationwide.

In the Tosco acquisition and in other actions in recent years, Phillips reflects trends in the oil business and sends signals on the outlook for oil and gas prices.

The company is an oil industry pioneer, dating 98 years to a discovery in Bartlesville, in northern Oklahoma, which remains Phillips headquarters to this day.

It is now a worldwide company with more than $20 billion in annual revenue from production in the North Sea, offshore China, the Caspian Sea area of Central Asia, Venezuela, Indonesia and Alaska.

In March 2000, Phillips paid $7 billion to buy Atlantic Richfield’s holdings in Alaska as that company merged with BP Amoco, now BP.

In February, it issued $7 billion in stock to acquire Tosco, in a deal that is scheduled to close later this year. The Tosco acquisition would make Phillips the second-largest U.S. refiner, after Exxon Mobil Corp.

It’s a controversial step.

“The refining business has been a disaster for 50 years, with poor returns on shareholders’ investment,” says Joseph Tovey of Tovey & Co., a New York-based investment banker specializing in energy issues.

But Phillips Chief Executive James Mulva thought differently for several reasons. In terms of operations, the deal seemed convenient. Phillips needed California refining capacity to handle its crude oil from Alaska.

So Mulva, a 32-year Phillips veteran who became chief executive two years ago, was receptive when Tosco Chairman Thomas O’Malley phoned in December to propose a sale of his company.

A more important attraction was strategic. Because of capacity shortages, the refining business has become profitable in the last year or so. Noting that, the stock market has driven up prices of Tosco and other refining companies such as Valero Energy Corp., Ultramar Diamond Shamrock Corp. and Sunoco Inc.

Looking forward, Mulva argues that the need for environmental investments, by reducing the number of players and adding further government regulation, will make the business more stable. He believes that refining is unlikely to fall back to a pattern of weak pricing and low returns on investment.

Analyst Tyler Dann of Banc of America Securities concurs--up to a point.

“The Tosco acquisition will look brilliant” if Mulva is correct about refining’s prospects, says Dann, who thinks that in many ventures Phillips is on the right track.

All that has significance for the price of gas. The fact that refiners need to make profits to finance environmental investments argues that gasoline is not going back to the $1-a-gallon levels that prevailed as recently as 1998. Prices will be higher.

In addition, Phillips’ purchase of Alaskan reserves signals its belief that crude oil prices will remain closer to today’s $27 to $28 a barrel than to prices of less than $20. If oil did go back below $20, analysts say, that $7-billion investment would no longer be profitable.

But today’s high gasoline prices threaten a real economic penalty. Can anything be done to alleviate the price crunch?

Well, yes, says economist Verleger. The federal government could raise the fuel economy requirements on passenger cars and light trucks, thereby forcing conservation. Politically that’s unlikely, he concedes.

But at the very least, California should be given the opportunity to come up with a better and cheaper additive than ethanol. There’s little doubt that the state that pioneered clean-air rules, with the nation’s leading air resources board, could produce a better fuel solution.

For the overall outlook, however, watch Phillips Petroleum to get a reading on the business. And try to conserve gasoline--because today’s prices will be around for a while.

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James Flanigan can be reached at jim.flanigan@latimes.com.

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High Road

Gasoline prices have fluctuated at much higher levels in the last year than they did in the late 1990s. Monthly prices for unleaded regular gasoline in California:

May 1: $1.87 per gallon

Source: California Energy Commission

What’s in the Price?

Here is a breakdown of the average retail price of $1.87 per gallon of gasoline in California as of May 1.

Crude oil cost: 61 cents

Refining costs*: 75 cents

State excise tax: 18 cents

Federal excise tax: 18 cents

State/local taxes: 14 cents

Gas station profit: 1 cent

*Includes 5 to 8 cents per gallon for oxygenate (clean-air) additives

Source: California Energy Commission